Where Do We Go from Here? Part I

In my June 24 and 29 blog entries, I made a few very modest suggestions for financial regulatory reform: a 9/11 Commission type of study of the causes of the financial crisis (and ensuing depression); a plan for rotating financial regulatory staff among the different financial regulatory agencies; the creation of a financial intelligence and contingency planning capability in the Federal Reserve; knitting the state banking and insurance regulators into a national "early warning" system of financial danger signs; financing financial regulatory agencies out of congressional appropriations rather than fees paid by the regulated firms. To this I now add another suggestion of modest reform: rather than create a Consumer Financial Protection Agency, just move the consumer protection divisions in the Federal Reserve and the other banking agencies to the Federal Trade Commission, consolidating them in a new Financial Regulation Division of the commission.

But the momentum for more-radical reform is powerful, and flat-out opposition unlikely to be effective regardless of its merit. So let me address in a constructive spirit what seem to me the far-reaching reform proposals that deserve serious consideration. These are: (1) gearing banks' capital requirements to the different phases of the business cycle; (2) making the Federal Reserve the systemic-risk regulator for the entire financial sector; (3) separating out commercial banking, mortgage banking, and money-market funds from other financial institutions, and making them safe; (4) regulating the compensation of top management of financial institutions that pose systemic risk; and (5) tightening regulation of derivatives, including credit-default swaps. I discuss the first three reforms in this first part of a two-part entry, and the other two reforms in Part II.

There are many high-risk industries, ranging from airlines to restaurants, but only one--the banking industry, broadly defined as it must be to include all other financial intermediaries--poses systemic risk in the sense that widespread failures of firms in the industry can turn a recession into a depression. Banking, as I keep emphasizing, is inherently risky. It involves the lending of borrowed capital; and creating a spread between the interest paid for the rental of the borrowed capital and the interest charged for lending that capital requires the bank to charge a higher interest rate than it pays, and to do that it must take a risk that the loan will not be repaid. In short, the bank's capital is at risk. One way to limit that risk is to place a low ceiling on the ratio of borrowed capital (debt) to owned capital (equity), the latter acting as a cushion against losses from defaults of loans made by the bank.

The tendency is for the ratio of debt to equity to rise in boom periods. The reason is that in a boom, values tend to be rising (house values for example), and this reduces defaults and so increases the market value of a bank's loan portfolio and other assets. (Defaults decline because in a rising market a borrower who has trouble paying off his loans can sell the house or other collateral for the loan at a profit and thus avoid defaulting, or refinance the loan because the collateral securing it has risen in value.) In addition, loan quality declines in a boom because there is greater demand for loans, for in a boom borrowers and lenders alike believe that rising values will prevent default even if the borrower is not creditworthy in the usual sense.

The problem is that the factors that drive up the market value of bank assets, and reduce loan quality, during a boom set the stage for catastrophe during a bust, at least a bust of the severity of the present one. A fall in the value of houses or other collateral precipitates defaults, aggravated by the declining loan quality during the bust; and with the market value of the banks' assets thus falling, their debt to equity ratio soars because debt is a fixed liability. (If at time t-boom a bank assets are worth $100, its debt is $90, and its equity therefore $10, at time t-bust its assets might be worth $90, its debt will still be $90, and its equity therefore will be $0.)

The solution is to require the bank to reduce its debt-equity ratio during booms. Banks will resist this solution because it will reduce their profits. Not that banks are indifferent to risk, but they are less sensitive to it than the regulatory authorities are (or should be) because to an individual bank the systemic component of risk is an "external" cost, as economists say. That is, it is a cost imposed on persons and firms with which the bank has no contractual relations (think of the millions of persons who have lost their jobs in this depression, without having been employed by or had any other contractual relation with any financial firm), rather than only felt by the firm that incurs it.

This reform of the capital structure of regulated banks could easily be implemented by the federal agencies that regulate banks, mainly the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision. There is thus no need to constitute the Federal Reserve the systemic-risk regulator, so far as systemic risks created by banks is concerned, at least if the Office of Thrift Supervision, which appears to have performed incompetently in the case of Countrywide and Washington Mutual, is either reformed or merged into the Federal Reserve. The concern rather is with nonbanks that might create systemic risk, as the investment banks and broker-dealers did in the current financial crisis--Bear Stearns, Lehman Brothers, Morgan Stanley, Goldman Sachs, and others. The first two have disappeared and most of the others have become bank holding companies, which has brought them under the regulatory supervision of the Fed. That leaves hedge funds, industrial loan companies (such as GE Capital, a financial company that is part of a nonfinancial company, General Electric), money-market funds, and perhaps forms of financial institution not yet invented. Hedge funds and money-market funds are under the actual or (in the case of hedge funds) potential regulatory control of the Securities and Exchange Commission, but perhaps rather than requiring the SEC to think about systemic risk the Fed should be given authority to determine that any financial institution poses systemic risk that requires additional regulation.

So consider hedge funds. Long-Term Capital Management, a large though not immense hedge fund the collapse of which in 1998 almost caused a global financial collapse, but which was bailed out by a consortium of Wall Street firms organized by the Federal Reserve, was highly leveraged by hedge-fund standards; its debt-equity ratio was 25 to 1. When the value of the securities in which its capital was invested suffered a sudden sharp decline, it had to start selling them in order to meet margin calls, and by dumping a large number of these securities in a short time it created a serious imbalance between supply and demand. That imbalance forced down the value of the securities, which compelled other owners of them to sell to meet their margin calls, thus jeopardizing the solvency of financial institutions other than just LTCM. This was an example of the interdependence of financial institutions, as a result of which a failure of one can set off a chain reaction that can endanger the solvency of many others and even of the entire global financial system. So there is an argument for empowering the Federal Reserve to identify such dangerous institutions and by limiting their leverage or by imposing other restrictions reduce the systemic risk that they pose. I have mentioned in previous blog entries the objections to this approach, which seem to me major; but worse approaches can easily be imagined.

A more radical approach, but one that has the virtue of clarity and definiteness that constituting the Federal Reserve as the financial system's systemic-risk regulator would not have, is to separate the banking system, defined as commercial banks and and money-market funds, from the rest of the financial sector, and, by the separation and by regulation of the type that the Fed, the Comptroller of the Currency, and the FDIC exercise over commercial banks, create a dike or protected zone against inundation from a collapse of other parts of the financial system.

The idea behind this suggestion is that commercial banks, though nowadays they supply less than a quarter of the total amount of credit in the United States, play a unique role in the overall credit system. The reasons are threefold. First, the banks provide essential financing for small- and medium-sized businesses (what is called "external finance")--businesses too small to meet their own financing needs out of retained earnings or by issuing commercial paper, or to be attractive to a lender that does not have an established relationship with the borrower, enabling the lender to evaluate creditworthiness. If a bank fails, though other lenders remain, borrowers from the bank may find it difficult to establish the kind of personal relationship with a new lender that would reassure the lender that the borrower was creditworthy.

Second, banks provide standby lines of credit that provide emergency funding when other sources of credit fails, as happened last September when the commercial paper market froze in the wake of the collapse of Lehman Brothers and the near insolvency of other broker-dealers that had been intermediaries in that market. Banks thus back up the riskier lenders.

Third, the banks are the normal conduit by which the Federal Reserve pumps cash into the financial system in order to increase the amount of lending, whether by lending money to banks directly or more commonly by buying Treasury securities from them (or lending to banks with the securities as collateral, by means of repossession agreements), thus increasing their lendable cash. It is easier for the Fed to recapitalize a bank than to recapitalize any other type of financial institution.

If commercial banks were forbidden to affiliate with other entities (such as an investment bank or a broker-dealer), and subjected to the type of "procyclical" regulation that I discussed at the outset of this entry ("procyclical" refers to the boom phase of the business cycle), the danger of a financial crisis engulfing the commercial banking sector would be substantially reduced. It would not be eliminated. Banking is inherently risky, as I have emphasized, and the risks frequently are correlated. If a nationwide housing bubble bursts and mortgages are a significant component of the asset portfolios of most banks, then most banks will experience an impairment of their capital, but the Fed should be able to prevent their collapse by pumping cash into them. In fact, the primary victims of the banking collapse last September were not commercial banks (though banks were victims, as I'll explain the second part of this two-part entry), let alone commercial banks unaffiliated with other types of financial institution, but were instead investment banks, broker-dealers, money-market funds, and the financial products division of a large insurance company (AIG).

Money-market funds are mutual funds, regulated by the SEC, that provide checkable accounts that usually pay higher interest than deposit accounts in commercial banks. They generate the interest that they pay their account holders by investing in commercial paper and other short-term securities. After a run on money-market funds began last fall following the collapse of Lehman Brothers, in whose commercial paper some of the funds were heavily invested, the federal government provided temporary insurance of the accounts. Money-market funds, like thrifts (mortgage banks), are so similar to commercial banks that all three types of financial institution should perhaps be regulated on the same principles, emphasizing safety and therefore separation from other types of financial institution. I am mindful, though. of the awkwardness of placing money-market funds under the systemic-risk-regulating authority of the Fed when those funds are regulated by the SEC rather than by a banking agency.

I do not mean to endorse the three forms of "radical" or far-reaching financial regulatory reform that I have described. I mean only to suggest that they have enough potential merit to warrant further consideration.

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School.
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Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.